0:11Skip to 0 minutes and 11 secondsBanks' credit risk assessment needs to be forward looking, and concentrate on businesses' future cash flows, and whether they will be adequate to repay the flow of interest payments that will be charged on a bank loan. A simple example might be a bank loan for the purchase of solar panels to be put on a roof, for example, if the output of surplus electricity can be sold to a national grid at a known price. In that case, the bank could see that the borrower had a future flow of cash receipts from which to service the loan payments. Such a risk assessment would be focusing on the future and on what the future uses of a loan could be.

0:52Skip to 0 minutes and 52 secondsJapanese banks' credit assessments would now focus on making such an assessment. But this wasn't always the case, and it's instructive to look briefly at the previous system prior to 1990 and what went wrong with it. Many people know that Japan experienced a big asset price bubble - the Bubble Economy - between 1985 and 1990 and that it took a long time for Japanese banks to recover from the persistent bad debt non-performing loan crisis that followed throughout the 1990s and which was not fully resolved until April 2005. One problem was that the bank loans extended by Japanese banks prior to 1990 were usually secured by a business's assets posted against the loan as collateral - often shares or land.

1:44Skip to 1 minute and 44 secondsThis appeared to be a very safe proceeding which would reduce the risk of bank lending. If a borrower could not repay a loan and defaulted, the attached collateral could be sold off by the bank instead. So the collateralisation of bank lending appeared to make the system safer. The collateral value of Japanese shares and land appeared to be indisputable, since land values had steadily risen since the end of the Second World War and stock prices has risen sharply after 1985. However, the well-known warning 'markets can fall as well as rise' is a warning that resonates profoundly regarding conditions in Japan in 1989 to '90 when the asset price bubble did finally burst.

2:34Skip to 2 minutes and 34 secondsShare prices plunged and so did the values of land and buildings to the extent that the markets almost froze. Collateral could not be sold after all, and it was, at first, impossible even to say what some of the collateral was actually worth for that reason. Some kinds of collateral could not be sold at all. So this aspect of the banking system which appeared to reduce risk had actually amplified it and needed concerted efforts by the government and regulatory authorities to sort it out in the end. In addition, it had always anyway been a rather backward looking arrangement, favouring those borrowers which had already accumulated assets - not necessarily the borrowers with the best prospects for growth in the future.

Case study: Risk management during Japan's 'Bubble Economy'

“Markets can fall as well as rise”.

What happens when aspects of the banking system intended to reduce risk, actually amplify it? Sonja Ruehl from SOAS Centre for Financial and Management Studies explores the case of Japan’s Bubble Economy.